Another Wave of Pain From the Housing Bust

I've written many columns this year on the nonperforming loan issues at U.S. banks, and especially at the money centers -- JPMorgan Chase (JPM), Bank of America (BAC), Wells Fargo (WFC) and Citigroup (C). In this column I will specifically examine the rapid increase in nonperforming closed-end second trusts. These are fully amortizing loans that are, in most cases, used for the purchase of a home in lieu of a portion of the down payment.

A typical structure here would be an 80% first trust combined with a 10%-to-15% second trust, which would reduce the home buyer's cash down payment to between 5% and 10%. A typical second-trust structure is a 20-year amortization with interest-only payments for the first five years -- and then, for the remaining 15 years, a full amortization with monthly principal and interest payments.

The conversion from interest-only to fully amortizing also results in increased monthly payments for the borrower. For example, let's say the purchase price was $300,000 with a 10% second trust for $30,000, accruing at 8%, with interest-only payments for the first five years. For this, the monthly payment would be $200.

When the loan enters its sixth year and the loan becomes fully amortizing, the monthly payment increases to $285 -- a 42% climb.

Since the housing bubble began to pop, followed by the collapse of Lehman Brothers, the potential for a surge in defaulted second trusts has been anticipated -- but, until this year, such a climb did not really come to fruition. During the past five years, the money centers have held nonperforming residential closed-end second trusts at about 4% to 5% of their portfolios for such loans.

During the third quarter, though, the default rates increased dramatically at Citi and BofA. The increases at JPMorgan and Wells have not been as big, that they probably will be soon.

At BofA, the number of defaulted second trusts tripled from the second quarter to the third, from about 4% of its portfolio to about 11.5%. At Citi, the move was from about 4.75% to 8.17%. Wells and JPMorgan respectively saw increases only from 6% to 6.5% and from 4% to 5.5%. Still, all four money centers are beginning to experience a marked increase in defaulted second trusts.

This pattern is also being exhibited most notably in the open-ended second trusts at BofA, where the default rate has increased from about 2% for the three previous years to about 5% today. Open-ended second trusts are typically lines of credit collateralized by home equity, which are accessed by borrowers through credit cards tied to the line of credit.

The signal being sent by this pattern, most prominently at BofA, is that borrowers are finally reaching their point of fatigue as default rates increase by necessity. The most disturbing aspect of this, as well, is that this has occurred even as carry costs have decreased on lines of credit, because they are tied to short-term rates and the Federal Reserve has driven them down as far as it's been able to do.

Also at BofA, there's been an increase in the rate of charge-off and a declining rate of recovery.

But, even as evidence of this pattern has begun to emerge, and even though it's likely to accelerate, BofA's stock price has continued to rise. Shares have moved from about $5 at the beginning of the year to about $11 today.

In short, the boost in housing activity this year appears to be distracting investors from the remaining large residual losses that still have to be absorbed by the banking industry, and particularly at BofA.